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High-Quality Stocks Beat the Market

Steven Goldberg

Here are my three favorite funds for playing the quality theme, along with a list of 16 pristine stocks.

I've been singing the praises of high-quality stocks for years now. And I'm hardly their only fan. But do they really outperform? For the first time, some solid research addresses this question.

See Also: 7 Great Stocks for the Long Term

A study by the Leuthold Group found that high-quality stocks have beaten the overall stock market over more than 25 years. From 1986 through April 30, high-quality stocks returned an annualized 11.8%, compared with 10.2% for the overall stock market, according to the study, by Jun Zhu, a Leuthold analyst, and Eric Weigel, the Minneapolis firm's research director. (Leuthold's benchmark for the overall market was an index that gave equal weight to the nation's 1,500 largest companies.)

What's more, high-quality stocks do best when the market is in free fall. Indeed, the outperformance of high-quality stocks is entirely due to their market-beating returns during bear markets. "High quality works when you really need it," Zhu says.


Look at the numbers. When the market, as represented by the Leuthold index, fell 11.6% from the start of May through August 2010, high-quality stocks lost only 8.9%. When the market plunged 52.6% from the start of November 2007 through February 2009, high-quality stocks lost 42.5%. Most strikingly, when the market plummeted 40.3% from March 2000 through September 2002, high-quality stocks gained 3.9%.

Quality doesn't always excel. It tends to lag in bull markets. Indeed, lower-quality stocks and the overall stock market have done better in the current bull market. From March 1, 2009 (nine days before the bull market began) through April 30, high-quality stocks returned a cumulative 175% — eight percentage points less than the market. High-quality stocks did much worse, relatively, during the 2002-2007 bull market, returning a cumulative 125%, or 41 percentage points less than Leuthold's measure of the overall market.

What's the outlook for quality now? It depends partly on your market view. In my opinion, global economic uncertainty remains high; I'm much more comfortable owning high-quality stocks than lower-quality fare. Weigel agrees. "It's probably worth emphasizing quality because the market seems a little bit toppy," he says.

But what is high quality? To me, it's kind of like the late Supreme Court Justice Potter Stewart's famous definition of pornography: "I know it when I see it." Similarly, when I see Apple (symbol AAPL), Google (GOOG) and UnitedHealth Group (UNH), I know I'm looking at high-quality stocks.

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